Morningstar Advisor - December/January 2010 - 46

Morningstar Conversation a reason you get paid. Individual investors don’t like the risk profile, because they’re looking at it in terms of one trade. Merger arbitrage is a great example of a very clean, easily explainable strategy. We’re offering it in our Diversified Arbitrage fund along with other strategies like covertible arbitrage and event-driven arbitrage. AL: This is a good example of how the CA: Oh, they’re worth five times the fees (laughing)! Seriously, here’s what I believe. Fees for things like what we’re doing should be somewhere in the middle of what a hedge fund charges and what a traditional, active mutual fund manager charges. Our funds are complex and require expertise that’s limited. Shorting and running arbitrage strategies are not run-of-the-mill stuff. We also provide diversification that you absolutely don’t get from traditional managers, because they own long-only equities. But it would be a sin if we charged 2 and 20 like the traditional hedge fund manager does. Over time, if we’re successful, other people will learn to do it well, too, and fees will come down. I’d be perfectly happy to be an early adopter and have a larger market share in a lower fee world. Alternatives as a Core NP: Based on your view of the economy over the next few years, will alternatives be a good investment? AL: Unemployment is 10.2%, and there’s a financial transactions of one sort or another. The sheer magnitude of the global financial system means that we can’t invest in the way that we used to. We have to develop more sophisticated technologies for dealing with a more complex world. CA: As a firm, we don’t take a strong view on more quantitative approach differs from the discretionary approach that originally characterized this strategy. It used to be that a risk arbitrager was one of these gunslingers who did a lot of investment banking deals, had a lot of experience with how deals went down, and had unique insights into which deals were going to break and which ones were going to go through. It was very much a testosterone-laden atmosphere where they did maybe three or four deals at a time, and one of them broke, two of them worked, and they either made hundreds of millions or lost hundreds of millions. It was a very different pursuit from what Cliff and I do. By taking a quantitative and systemic approach, we can provide an alternative for investors, while offering them the type of protections and transparency that the traditional hedge fund strategies don’t offer. CA: Our funds pursue things somewhat differently, but you’re right—there’s a common ground to what we do. You’re looking at a hedge fund and alternatives world that claims everything they do is genius. Genius exists in the world, but right now, the hedge fund world is charging as if it’s all genius. Andy’s approach is to say, “What can we systematically extract from the top-down? They are doing strategies that look replicable, and not things that you should be paying 2 and 20 for.” NP: Your mutual fund strategies are definitely not as expensive as hedge fund strategies, but the expenses are higher than the average equity fund. Are these expenses worth it? the direction of the economy. Part of the point of hedge funds and alternative strategies is that they are not bets on direction. They are bets on spreads, long something, short something, and arbitrage strategy, like merger or convertible arbitrage. They don’t always work, but the beauty of them is that you don’t have to be right about the direction of the economy or the stock market. NP: Are these non-directional strategies something advisors should consider buying and holding for their clients? CA: I absolutely think so. I don’t think market timing is ever recommended, except for maybe during times of true extremes. For example, at the end of 2008 and the beginning of 2009, there were a bunch of arbitrage strategies that were priced to Armageddon that, unlike the stock market, even if Armageddon came to bear would have been profitable. Even now, many arbitrage strategies are way cheaper than they have been on average over the past 30 years. reason for that. It’s because our labor force is too expensive; it can’t compete with those in China and India. We’re going to have to retrain our workers. That process is going to take anywhere from two to five years. During that period, we’re going to be rejiggering our financial and regulatory infrastructure, and if we’re successful, there’s going to be a tremendous recovery and even greater growth than we’ve seen over the past 20 years. But it’s going to take a significant amount of time and effort, and it’s fraught with great risks. This kind of economic scenario is ideally suited to alternatives. When you have such complex economic interactions, the traditional long-only 60/40 model of investing is simply not adequate, because it doesn’t take into account the dynamics of these economic cycles that are far shorter and more erratic than they were 50 years ago. We’re now living in a world of 6.5 billion people, and each of them engages in That said, if we ever saw the spreads go away, we would stop doing the strategies. We would cut our risk all the way down to zero if we saw no spread between a target and an acquirer, and our clients should go do something else. But both of these cases are extremes. Aside from extremes, you shouldn’t try to time this strategy. It should be a steady allocation of a chunk of your portfolio to be a diversifier. AL: I agree. We designed these products to serve as part of the core investment of a portfolio, not as a satellite. Paul Samuelson said it best. Macroeconomists have predicted five out of the past three recessions. It’s 46 Morningstar Advisor December/January 2010

Morningstar Advisor - December/January 2010

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